Monday, April 23, 2012

Andy Xie warns that Hong Kong's dependence on the housing sector to drive economic growth is feeding another asset bubble. When it bursts, he says, the government should resolve to kick the addiction

Andy Xie

April 23, 2012

Hong Kong did not learn from the property crash and economic collapse of 1998. Instead, it has tried hard to reinflate the bubble. After squeezing supply for over a decade and with the help of the US Federal Reserve's zero interest rate, the bubble is back. But it is a Pyrrhic victory.

Hong Kong's economy is suffering. Between 1997 and 2011, nominal gross domestic product grew by 2.6per cent, per capita income by 2per cent, and the average salary by nearly 2per cent every year. Over the same period, the cost of living shot up - oil prices quintupled and food prices doubled - while China's labour costs tripled. It's easy to see why Hong Kong people are not happy.

More damaging is how concentrated in property and finance the Hong Kong economy has become. In 1997, aside from the property bubble, Hong Kong was leading the Pearl River Delta's industrialisation with the attendant high-valued-added activities such as research and development, trade finance and marketing based in Hong Kong.

But the high cost of doing business due to high property prices and rent has pushed away such businesses. The only new business that has helped Hong Kong is retailing to mainland tourists. But selling European products to Chinese tourists is a low-value-added business. Only landlords benefit significantly from it.

The social cost of squeezing supply to support a high price could precipitate social turmoil. While Hong Kong is considered a high-income economy, numerous families, many with members of three generations, live in one room. More than two-thirds of Hong Kong's land is undeveloped. And reclamation, the main source of new land for Singapore, has potential in Hong Kong. So, while popular perception attributes high property prices to a land shortage, it is utterly untrue. Hong Kong's elite fuels this misperception because they want to keep people in the dark.

Despite its gross mismanagement, Hong Kong hasn't collapsed because it can suck juice out of China. Hong Kong's prosperity depends on arbitrage opportunities arising from the mainland's inefficiencies. As the mainland becomes more efficient, such opportunities will become scarcer.

Mainland prosperity has also created a new business for Hong Kong - monetising China's political power offshore. This round of Hong Kong's asset boom has much to do with this force. That business, however, won't last, either. China's political reforms will come sooner than expected.

No great city can thrive just on dodgy businesses like property speculation, arbitrage exploiting someone else's loopholes, or helping powerful people rob their countries. True, such businesses also exist in London and New York. But those cities have diversified activities to provide a decent living for the local populations, even as the elite profit from the dodgy activities. If Hong Kong's economy is to thrive, it must make Hong Kong people competitive.

After the 1998 collapse, the Hong Kong government took to setting a minimum price for land auctions. As the government is the only land supplier, it caused the economy to restructure around the government-mandated land price. Economic activities that compete globally couldn't survive in such an environment and decamped as a result. On the other hand, Hong Kong's Cantonese education has produced a generation ill suited for economic activities related to serving mainlanders' needs, dodgy or otherwise.

Hong Kong's economic winners and losers are determined by a game of when one buys a property. This game redistributes income; it doesn't make the pie bigger. Because land supply is controlled, downstream activities are just ripples in a river where the water level is fixed. Hong Kong's market economy, while often touted as laissez-faire, is not really market oriented.

Unless Hong Kong cuts property from its economic centre, it doesn't have a good future. Property isn't a productive asset. It is worth money only because the people who use properties are competitive. When policy squeezes up property prices by restricting supply, it just prices more and more people out of the modern economy. As their numbers accumulate, discontent will grow.

Hong Kong must control land supply according to its development needs, not to set prices. The city should first set targets for the size of its population and housing conditions - say, a minimum living space of 200 square feet per person - and land supply should follow. The current property bubble will eventually burst, like the ones before, when the US Fed raises the interest rate. And when it does, the government must resist manipulating supply to support prices. It should be viewed as an opportunity to restructure the economy.

To control the damage from a property crash, the government should tighten prudential regulations on the banking system. Hong Kong has an unusual capital accounting requirement for mortgage lending. At 8per cent of the standard capital requirement for lending, Hong Kong banks essentially need no capital for mortgage lending. This is why Hong Kong's mortgage interest rate is so low.

Hong Kong's banking system is a massive volatility amplifier for the property market. It may be good for developers, but it's not good for the economy. Raising the requirement to 50per cent, as it stands in mainland China, is a step that the government can take immediately to strengthen the economy.